An Overview of the New Central Securities Depository Regulation

The Central Securities Depository Regulation (CSDR) is a new EU regulation primarily concerned with improving securities settlement and the regulation of central securities depositories. The regulation’s core themes will be recognizable to those familiar with the existing legislation of European Market Infrastructure Regulation (EMIR) and Markets in Financial Instruments Directive II (MiFID II), reduction of risk and increased efficiency of European markets.  As with previous pieces of regulatory reform, CSDR will affect market participants across the board, with multiple actions required to ensure compliance.

As the name suggests, CSDR is principally aimed at regulating central securities depositaries; the specialist organizations – such as Euroclear and Clearstream – who hold financial instruments in their dematerialized form, for transfer, clearing and settlement. However, the impact that will be of wider interest to market participants will be the Settlement Discipline reform, which aims to achieve greater harmonization of securities settlement across European markets. In its current form, CSDR introduces the contractual need for mandatory buy-ins (via a buy-in agent) against the failed delivery of securities:

“Parties in the settlement chain shall establish contractual arrangements with their relevant counterparties that incorporate the buy-in process requirements…” (Regulation EU 2018/1229)

Transactions in scope under CSDR include those settled through CSDs such as bonds and shares, money market instruments, units in investment funds and emissions allowances. For the mandatory buy-in regime, OTC trades in derivatives, repos and stock lending are also in scope, and OTC documentation will need to be amended to ensure regulatory compliance mandatory buy-in requirements.

CSDR is currently expected to come into force on February 1, 2022. Our view is that now is the time for planning and preparation amidst the medley of regulations financial institutions will have to tackle in the next 12 months.

The U.K. government has published a statement on which EU regulations it will implement after Brexit, which largely draws a line that will see it implement regulations in force as of December 2020, but not those which come after. That being the case, CSDR is not expected to be enshrined into English law; this of course raises the potential problem of U.K. firms having to operate with clients in a dual regime environment.

Settlement Discipline – Impact Beyond Documentation

The goal of CSDR in reducing securities settlement reaches beyond improving the operational aspects of processing and matching transactions; it goes a step further to introduce cash penalties against market participants whose transactions fail to settle on the intended settlement date. In doing so, it not only necessitates the need for a legal solution within a firm’s trading documentation, but adds complications in the front office and operational functions of market participants.

Due to the “chain” nature of transactions in the SFT world via title transfer, delivery fails are not an uncommon occurrence. Indeed, the industry trading agreements have developed over time to include carve-outs for delivery fails and mechanisms to isolate and rectify individual fails rather than collapsing an entire commercial relationship. However, the impact of a potential cash penalty on already slender profit margins on repo and securities lending transactions should not be underestimated. SFTs are often referred to as the central cog of liquidity within financial markets – a contraction of liquidity due to CSDR uncertainty would certainly be unwelcome. Significant resources will need to be committed across various departments of market participants to ensure compliance with changes to Settlement Discipline imposed by CSDR.

Who is affected?

As with existing European financial legislation, the scope of CSDR is broad and will touch all corners of financial markets, including:

• CSDs – New authorizations required via updated licenses under CSDR. Daily reconciliation of securities received versus participant accounts. Reporting required on a single legal entity identifier (LEI) level.
• Sell-side – Broker-dealers will naturally hold a large volume of SFTs, and as such, will also be parties to the largest number of master agreements potentially requiring legal amendment. As market makers primarily filling client orders in volume, sell-side participants are arguably at greater risk of falling on the wrong side of mandatory buy-ins and cash penalties.
• Buy-side – Asset managers would be likely to have a more streamlined library of trading agreements with their panel of brokers and may therefore face less of an operational challenge than sell-side parties; however, remediation of SFT documentation will still be required.

There is consensus amongst the industry bodies in support for the goal of reducing the amount of settlement failures through the recalibration of Settlement Discipline under CSDR. ICMA, ISLA and ISDA – the framers of repo, securities lending and derivative master agreements respectively – have published support for these objectives. However, there has been vocal opposition to the practicalities of how this would be achieved via the mandatory buy-in provisions and use of a buy-in agent. In a September 2020 briefing note on CSDR, ICMA noted:

“…cross-industry concerns that not only is it likely to be damaging to bond market liquidity, efficiency and stability, but many requirements of the regulation potentially render the initiative unimplementable.”

This stance is in line with broad concerns expressed by ISDA and the Futures Industry Association:

“…the CSDR settlement discipline regime does not appear to have been devised with derivatives transactions in mind. Accordingly, applying the cash penalties and mandatory buy-in regimes to settlement fails arising in the context of derivatives transactions is likely to lead to unintended adverse consequences and distort the economic agreement of the parties in relation to impacted transactions.”

In particular, ISDA call attention to a circumstance where a derivative transaction which, for all intents and purposes, should sit outside the remit of CSDR, is inadvertently caught by the regulation against the intended purposes. A core risk mitigation feature of both cleared and uncleared derivatives is the exchange of variation margin, which is calculated and exchanged on a daily basis (as a minimum). Given the stability and liquidity of high-grade government bonds, such instruments are widely written into derivative contracts as acceptable collateral for variation margin. The settlement of government debt being exchanged as margin would take place at a CCP, thus unintentionally pulling transactions under an ISDA into the scope of CSDR.

Lobbying against the current form of the regulation – particularly of the use of buy-in agents – continues; however, the EU has so far stood firm with strong policy rationale. With only months to go until implementation, unless the further delay is agreed, it seems that a confirmed industry protocol or collaboratively agreed standard provisions to address the impact of CSDR in master agreements it still some way off.

The challenge facing institutions and their customers is how to manage legal remediation projects on topics such as CSDR with other regulatory obligations falling around the same timespan – particularly LIBOR and initial margin. Clearly, many institutions will need external assistance to supplement their existing teams, such as law firms, consultants and alternative providers of legal services.

Cost will be a major element, but the industry as a whole is developing more sophistication in its ability to combine different regulatory workstreams. Firms’ GMRA and GMSLA documentation is likely to be open for review at present as part of Brexit planning, LIBOR reform or BRRD; the challenge is whether firms can avoid having to separately open, review and amend agreements for each individual compliance obligation.

The more efficient model is to start reviewing and extracting data on one project, which will likely be required on other projects. For example, if your Brexit or LIBOR workstreams require you to open and review existing trading documentation, can you use that opportunity to extract key data, such as client contact details, for use on CSDR amendments or to search to see whether a LIBOR rate is referenced in those agreements? If so, can that data be stored and shared later with other project groups? And once you have that data, can you re-use it for future workstreams, such as business re-organizations and efficiency projects?